Fixed Exchange versus Floating Currencies

Major Floating Currencies

As of today, the two major currencies of the 21st century are the US dollar (USD) and the Euro (EUR). These currencies are recognized worldwide and used in international transactions as well as deferred payments. Since the gold and silver standards were abandoned by developed economies during the 20th century, currencies such as the USD and the EUR are said to ‘float’ freely in the foreign exchange markets. Their price varies daily as it fluctuates according to the forces of supply and demand as well as their reputation. Certainly, the Central Banks implement monetary policies in their respective countries, however, their control over the currency’s value is not absolute.

Nevertheless, not all currencies have the stability or international standing needed to withstand the winds of the global foreign exchange market. In fact, a major or minor fluctuation in the world’s markets could send small economies with floating national currencies into a recession, hyperinflation, or worse. Therefore, just as some countries fixed or ‘pegged’ their currencies against reserves of precious metals in the past, some governments have decided to fix the exchange of their national currencies against the EUR or the USD. In fact, the EUR itself was created as a common currency amongst neighbouring nations and intensive trade partners who wanted a very fixed exchange rate (1:1).

Fixed Exchange Currencies

Small economies, particularly countries who engage in substantial trade, are particularly vulnerable to currency risk and volatility. This means that their domestic economy and their citizens’ savings could be severely harmed by monetary fluctuations. For example, a severe devaluation of the national currency might lead to high inflation and an unsustainable cost of living. Similarly, an abrupt valuation of the currency could negatively affect the country’s exports, trade balance, and its GDP. Therefore, some governments, through their Central Banks decide to peg or fix the domestic currency’s exchange against a major actor such as the USD or the EUR.

A fixed-exchange currency provides small countries and economies with steadiness in the domestic markets, stable costs in terms international trade, and controlled inflation. However, a fixed-exchange implies that the smaller economy gives up its monetary policy autonomy. In order for a fixed-exchange to work, the smaller economy has to follow the monetary policy of the central financial authorities of the major currency, in this case the Federal Reserve or the European Central Bank. Furthermore, the smaller economy needs to maintain substantial reserves of the major currency in order to conduct foreign exchange market operations. Only by selling and buying its own domestic currency against the USD or the EUR, can a Central Bank defend and sustain its fixed exchange rate.

Some examples of fixed-exchange currencies are the West African and the Central African CFA Franc, official currency in 14 nations. Although managed by separate Central Banks both CFA Francs are interchangeable with each other at par (1:1) and are fixed against the EUR at an exchange of 655 to 1€. Similarly, currencies such as the Bahamian Dollar and the Cuban Convertible Peso have a fixed-exchange of one-to-one with the USD. Furthermore, some countries and territories have completely transformed their economies to use a major currency. These include El Salvador, Ecuador, Puerto Rico, the British Virgin Islands, and Panama, amongst others.

Managed Float Regime

Regions and governments that wish to maintain economic independence and some monetary autonomy while protecting their domestic economies from major volatility use some sort of managed float regime. Depending on how it is used, a managed float regime can be considered currency manipulation and unfair competition. However, most Central Banks employing this method do not impose artificial exchange rates or systematically devalue their currency. Rather, they utilize the foreign exchange markets to prevent sharp movements in the currency value that might be harmful to their economies.

Currency value and exchange rates as well as monetary policy are important factors to keep in mind when investing. For international investors, currency represents both a risk and an opportunity. Be it the opportunity of increased exports brought about by a floating currency or the stability of having a fixed exchange, monetary policy varies between countries and is a determining factor to consider when investing.

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